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Michael
Pettis at China Financial Markets makes a compelling case why Spain is
destined to leave the euro. For ease in reading, I added the subtitles in
bold.
In my forthcoming book (Princeton
University Press, February 2012) I argue that there is little chance that the
euro survives the next few years, or that we avoid major sovereign
restructurings and/or defaults. I am not just talking about Greece, by the way. I think a Spanish devaluation
(accompanied inevitably by a sovereign debt restructuring) is pretty much a
sure thing too, along with devaluations among many of the other obvious
suspects.
After I turned in the completed manuscript of my upcoming book, my editors
were a little worried about my extreme pessimism over the euro, and suggested
that I hedge a little so as not to look foolish if these things didn’t
happen, but honestly I am less worried about that possibility than I am
worried that by the time my book comes out Spain will have already abandoned
the euro. I really
don’t see any progress at all in resolving the euro crisis, and the
longer it takes to resolve, the more financial distress peripheral Europe
will suffer, making a resolution of the crisis all the more difficult and
urgent.
Last week the Financial Times had an editorial, “Politics is
adding to Spanish woes”, which they ended with the following:
While they wait, Madrid should stick with the policies it is pursuing but
intensify its work on the banking sector. If high yields persist, Spain can
bear it for a while – no one should buy the kabbalism
according to which a certain level of yields marks the entrance to a black
hole. The eurozone needs to convince investors it
will be able to act if panic persists, which it can best
do by giving the new rescue fund a banking license.
But the best remedy against panic is reassurance. A greater sense of
political competence in Madrid and of decisiveness in Brussels would do
wonders.
I see it very differently. Policy is certainly adding to the problems in
Spain, but I don’t think it is because, as the editorial claims, Prime
Minister Mariano Rajoy has mismanaged the political
process, and I am not sure that greater political competence in Madrid, or
decisiveness in Brussels (!), will do anything at all, let alone wonders.
Too Late to Save Spain
The problem, I think, is much more serious than Rajoy’s
flunking hard choices, and I don’t think there was anything he could do
to increase the country’s credibility in a significant way. We have long passed that stage.
Why? Because, as I have been suggesting for
the last six to twelve months, Spain has already started on its downward spiral
and there is almost nothing Rajoy or anyone else
can do to prevent all parts of the economy – workers, small businesses,
large businesses, creditors, depositors, and yes, policymakers – from
acting each in their own way to increase the debt burden, increase economic
uncertainty, make the balance sheet more fragile, and reduce growth. These different economic agents by now
are simply behaving rationally in response to declining credibility, and
unless we expect from them a huge burst of irrational cheer, there is no
reason to expect them to change their behavior.
All of their actions, of course, reduce credibility further, and as
credibility drops it simply reinforces the adverse behavior of all the
rationally misbehaving economic agents. This is the dreaded self-reinforcing loop typical of countries in the
nightmare stage of a debt crisis.
We have seen this process many times before in the history of sovereign debt
crises, and it is mind-numbingly mechanical. No matter how well Rajoy
implements fiscal austerity (assuming that this is indeed the right thing to
do), no matter how many times policymakers plead with markets to give them
time to implement reforms, no matter how often the government begs workers
and businesses to have more confidence, at this point it is going to be
incredibly difficult for Spain to escape from this cycle.
Problem is Arithmetic
The problem is arithmetic, not confidence. Basic balance of payments math tells us
that in order to repay its external debt Spain must run a large trade
surplus. If it
ends up however with a trade surplus caused simply by a collapse in domestic
demand and soaring unemployment, which is the current path, domestic politics
will become unmanageable and Spain will eventually be forced to leave the euro
in order to regain competitiveness in a less painful way. One of the good things about a
well-functioning democracy is that it simply won’t permit a debt crisis
to be resolved by forcing an unacceptable burden onto the working population.
Trade Surplus Math
The requirement for a trade surplus is the key point. Even if there were no capital flight,
and assuming we are unlikely to see large investment-driven private inflows
into Spain for many years – a pretty safe bet, I would think –
Spain must run a large trade surplus in order to repay foreign debt holders
(technically Spain must actually run a current account surplus, but in
practice this means a trade surplus). Of course capital flight, which is already large and rising, as I
will discuss later, means that Spain must run an even larger trade surplus
than otherwise if it is going to repay external debt.
Under what conditions can Spain run a large enough trade surplus? There are really just four ways this
can happen. One way
is through a collapse in domestic consumption caused by many years of
unemployment above 20%. In this case eventually relative wage growth will be sufficiently
negative for Spain to regain competitivity,
although declining prices and wages also mean that the debt burden will get
worse during this period. Of course the political cost of many years of unemployment above 20%
will be tremendous and almost certainly unsustainable, and we are already
seeing this in the growing popular rage in Spain against the political
establishment. There is
no reason to think that popular anger won’t get worse.
The second way is for Germany to reflate domestic demand enough to cause its
large trade surplus to become an equally large trade deficit. This will allow eurozone
countries like Spain to reverse their own deficits, which under the
conditions of the monetary union were simply the flip side of Germany’s
surplus. If
Germany does this, however, its own real growth will slow significantly and
may even become negative for many years.
In addition Germany’s debt burden will rise rapidly, because in order
to reflate it will need to cut consumption and income taxes sharply, to boost
fiscal spending, and to absorb rapidly rising non-performing loans in its
banking system. As of
now there seems little chance that Germany will do this, especially as it
will also need to guarantee Spanish debt directly or indirectly to stop the
downward spiral in the debt markets.
The third way is simply a variation on the second. The euro would need to fall sufficiently
to allow the whole eurozone to run large –
huge – trade surpluses. This is Martin Feldstein’s argument in last week’s
Financial Times, A rapid fall
in the euro can save Spain, where he suggested that “financial
markets may already be in the process of forcing a solution upon Brussels
policy makers”.
The problem with this, however, is obvious. It can only work if Europe were small
enough and the rest of the world were in good enough economic shape that the
global economy could absorb a sharply rising European trade surplus.
But with deficit countries doing all they can to reduce their deficits, and
surplus countries doing all they can to maintain or increase their surpluses,
it is hard to imagine how Europe, which is already a surplus entity, can
possibly increase its overall surplus enough to bail out peripheral Europe.
That leaves the fourth way. Spain can freeze banking deposits, abandon the euro, and devalue. This would be very painful, but it
would allow the country to regain international competitiveness in much less
time and run a trade surplus (mainly at Germany’s expense, by the way)
with much lower levels of unemployment and economic self-destruction. Of course it would also mean a soaring
debt burden as the new currency devalues relative to the country’s
euro-denominated debt, and so would almost certainly come with a debt
restructuring (again mainly at Germany’s expense) that would reduce the
debt servicing costs.
These are the four conditions under which Spain can run a sufficiently large
trade surplus to service its external debt, and since three of them are
impractical or highly unlikely, we are left with the fourth. This is why I think the probability of
Spain’s abandoning the euro is much higher than its staying in the
euro.
Downward Spiral
Meanwhile, and in case there is any doubt, we have had more chilling news
that indicates just how firmly Spain is caught up in the downward spiral. First, Madrid last week downgraded its
growth forecasts, saying that the recession would continue into 2013.
This apparently shocked the market but I cannot see why. I have argued many times over the past
three years that quarter after quarter policymakers are going to adjust their
forecasts downwards, not because they have been dishonest in their previous
forecasts but simply because they never take into consideration the impact
that rising debt and declining credibility have on forcing adverse changes in
the behavior of economic agents.
Expect Downward Revisions
The economy will always perform more poorly than expected because rational
economic agents will always behave in ways that automatically make matters
worse. Expect many more years of downward
growth revisions, not just for Spain but for all of Europe.
Capital Flight
Second, money is fleeing the country. An article in Germany’s Spiegel describes just how bad it is:
Capital outflows from Spain more than quadrupled in May to €41.3
billion (compared with May 2011, according to figures released on Tuesday by
the Spanish central bank. In the first five months of 2012, a
total of €163 billion left the country, the figures indicate. During
the same period a year earlier, Spain recorded a net inflow of €14.6
billion.
Capital flight is one of the most powerful parts of the downward spiral, and
of course it is extremely self-reinforcing. Capital flight is driven largely by
disinvestment and bank deposit withdrawals, and the former reduces growth
while the latter both reduces growth and increases balance sheet fragility.
We may have already reached the point where it will be impossible to stop the
outflows, and I can’t imagine that already-reluctant Germans are going
to be happy to reconcile their increasing investment in Spanish government
bonds with increasing disinvestment by Spanish businesses and depositors.
Silliness From Feldstein
I had bookmarked Martin Feldstein’s column with an
intent of challenging the notion that a falling euro could save Spain,
but I failed to get around to it. The irony is just a couple years back, nearly everyone thought the solution to the global
financial crisis was a cheaper dollar.
Indeed, a quick search shows that on August 24, 2011, less than a year ago,
Feldstein argued in a Bloomberg Interview (Dollar
Decline Benefits U.S. Economy) that "A lower dollar means
more exports, and it also means a shift from consuming imported products to
consuming goods and services that we produce in the United States".
Apparently a lower dollar and a lower euro are both needed. Given the euro is
57% of the US dollar index just how likely is that?
Moreover, a falling euro, even if it did help the eurozone
as a whole, would hardly help Spain more than Germany given Germany's
productivity advantages over Spain.
What Spain Needs
Spain does not need a lower euro, it actually needs
a higher one (with Spain back on the pesata).
Alternatively (and in fact preferably) Spain can indeed benefit from a lower
euro (provided of course Germany is back on the Deutsche Mark.
The key point is that it is complete silliness to think anything else but a
breakup of the eurozone (coupled with genuine work
rule reform) can help Spain.
What About Italy?
Pettis did not mention Italy in his email, but I think Italy exits the eurozone before Spain.
Anti-euro and anti-German sentiment is high and rising in Italy, and
technocrat prime minister Mario Monti will be gone
by April.
It will not take much to push Italy over the edge given the rise of the Five
Star Movement. For details, please see
·
Mish on
Capital Account: Discussion of Social Media Panic in Italy, Soaring Yields in
Spain, and the Upcoming 20th Euro Summit, Bound to be Another Failure
·
Time-Lapse
Interactive Graph Shows Stunning Rise in Anti-Euro Sentiment in Italy
·
Italy
"Gasping Like Beached Whale"; Berlusconi Reiterates Euro Exit
"Not Blasphemy"; Beppe Grillo Discusses "Taboo of the Euro"
·
Six Reasons
Why Italy May Exit the Euro Before Spain; Ultimate Occupy Movement.
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